Argentine Tango Ft. VCs & Founders: a Story on Digital Ad Spend

Should that $100,000 be spent on more Facebook/Google Ads? What about banking some and paying the engineering team $5,000 more each so they feel more in-line with the sales people? Could you use that money to improve the net promoter score by .3? How about a new Customer Success hire; how many accounts is the team currently managing? Many high profile tech executives have become outspoken and concerned about funneling an increasing percentage of VC dollars into digital ad spend, including Andrew Chen, Chamath Palihapitiya, Michele Romanow, Fred Wilson, and others. The status quo for at least the last decade has been: raise venture capital, pay and hire employees, pay rent, and then hack some growth! Recently, that path is being challenged.

Context 

For context, 2019 is the first year in which digital advertising spend, about $130 billion, is set to outpace traditional, offline advertising spend, about $110 billion. Google, Facebook, and Microsoft are slated to be the top 3 digital advertising platforms, with Amazon scaling up quickly. Google and Facebook together will make about 59% of the digital advertising revenue/spend, respectively 37% and 22%, or about $46 billion and $26 billion. Microsoft is next at about $4 billion in net digital ad revenue. The sky is blue and the grass is green for founders who can take advantage of these platforms and speak to a particular audience at scale, but there is definitely a duopoly in digital ad spend if two companies receive over 50% of the ad spend, and the next largest receives about 4%.

According to HubSpot’s 2019 survey of 290 startups, “41% of respondents list using digital ads (Google Ads, Facebook, Twitter) in their demand generation efforts. The majority of startups spend less than $100,000 per year on digital ads and 74% of startups implemented digital ads within 2 years of founding… Fewer than 4% of respondents said that their organizations use traditional TV, radio, or billboard ads for demand generation.” In another interesting stat, 93% of responders mentioned that they begin spending on digital or traditional ads within 2 years of founding the company, 53% within the same year. Of these respondents, the majority are pre-Series B. To summarize, it appears after 2 years, over 50% of early stage startups will spend a sizeable chunk of their raise on digital advertising.

Thesis

The question is: how much is too much? Andrew Chen writes: “When companies are too reliant on paid acquisition for increasing user growth, their average Customer Acquisition Cost climbs. This increases the amount of time a user must be retained to become profitable, shifting the unit economics and potentially turning growth against the company.” In other words, as you pay more for users, CAC increases, and as CAC increases, LTV needs to increase to maintain those healthy KPIs that make VCs happy.

At the same time, Chamath believes that VCs want you to spend more money to boost those KPIs as fast as possible so that your user growth, organic or inorganic, will subsequently grow, presenting a rose-colored picture to the next set of VCs. From his 2018 Annual Letter, “Startups spend almost 40 cents of every VC dollar on Google, Facebook, and Amazon… Advertising spend in tech has become an arms race: fresh tactics go stale in months, and customer acquisition costs keep rising.” As a result of VC expectations, a function of their LPs opportunity costs, startup teams are forced to find product market fit as fast as possible, even at the expense of inflated user growth via digital ad spend. “Ad impressions and click-throughs get bid up to outrageous prices by startups flush with venture money, and prospective users demand more and more subsidized products to gain their initial attention.” This makes quite a few assumptions, yet, technology companies, newly funded each year with billions of dollars, will definitely move the needle on this type of advertising, especially as it is the quickest way to achieve the desired KPIs.

Looking back to the HubSpot responses source and Chamath’s letter, some analysis is possible. 74% of 290 HubSpot responders implemented digital advertising within 2 years of founding their company. Let us put in a seed fundraise of $2M for those 74%. Using Chamath’s 40 cents/dollar, about 215 companies would spend $800K on Google, Facebook, and Amazon, potentially within 2 years of being founded. Using HubSpot’s 74% digital ad stat, about 215 companies would primarily spend $800K on Google/FB ads. We can very roughly say that the difference between the two total amounts, from Chamath’s to HubSpot’s, respectively, is what Amazon receives for AWS services and advertising. $216M-$96M is $120M.

The $2M raise isn’t a perfect number to use for all the respondents in HubSpots survey, as a portion were Series A, and a similar portion had not raised, but this example is used to show that digital ad spend is burning a significant hole. To expand the thought process in this example, look at how this burn affects multiple parties.

  1. $800K is $800K of LP money, which needs a return. This return comes from an asset class in which 90% of the individual investments fail. Chamath’s letter reads, “Their money, after all, is what pays the VC’s newly trumped up management fee: marking up Fund IV in order to raise money for more management fees out of Fund V, and so on, is so effective because fundraising can happen much faster than the long and difficult job of actually building a business and creating real enterprise value.” This suggests that a startup’s burn rate is materially increased in order for their next fundraising process to happen more quickly, such that the exit can happen quickly, for the purpose of showing the return to LPs, thus pushing the need for a new and bigger (more income from % fees) fund.
  2. Founders will spend this money, and then, as Andrew Chen pointed out, need to “re-spend” plus augment it for growth to keep improving metrics. Founders and employees will feel the effects in their stock ownership dilution as the founders raise more money to keep the story moving along. Employees, in particular, will feel this as their risk/reward ratio for working for a startup starts to not look as attractive. Of course, a bigger piece of a smaller pie is sometimes not as rewarding as a smaller piece of a huge pie, and the risk of the pie not growing is mitigated by a new raise. However, assuming again that over 90% of startups fail, the equity ownership plans typically are not extremely lucrative. From Chamath’s letter: “Although originally helpful as a way to incentivize and reward employees for working hard for an uncertain outcome, in a world where startup valuations are massively inflated, employees are granted stock options at similarly inflated strike prices.” The incentive structure is meaningful to employees, and it is affected by business that’s inflated with revenue from inorganic traffic that could potentially not exist if funding was to be reduced.

Conclusion

To say the least, advertising is an interesting game. It attracts employees, customers, and investors. However, it can lead to a concave function, in which digital spend given the right pockets can produce an ROC, but there seems to be quite an attractive argument for a point of no return.

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